Strangle Spread: A Guide To This Options Trading Strategy

The Strangle Spread Options Trading Strategy

Introduction

Options, and combination trades such as the strangle spread, can be a very useful tool for both novice and seasoned traders and investors. Options can be used to mitigate risk and hedge a position in the underlying asset, to trade market direction and even to trade changes in implied volatility.

Some popular strategies include the bear put spread, the bull call spread and the iron condor. The option strangle spread is a versatile strategy that can be either bought or sold, depending on the trader’s goals.

Description of the Strangle Strategy

A strangle spread consists of two options: a call and a put. The idea behind the strangle spread is to “strangle” the market.

This means that the trader that is long the spread wants to give themselves the potential for profit if the market goes up or down. The trader that is short the spread is looking to collect premium and potentially profit if the market stays within a defined range.

A long strangle trade would look like this: Suppose that a trader has been watching stock TTT which is currently trading for $40 per share. The company has a major earnings announcement in a few weeks, and the trader feels the stock could see a significant move but is unsure about the direction. The trader could execute a long strangle by purchasing the two month $42 call and two month $38 put for a total premium of $4.

Strangle P&L Diagram

Because the trader has purchased the options, their risk is limited to the $4 premium paid. The position has unlimited profit potential to the upside, and down to zero on the downside.

The break-even of the position is calculated as the long strike price plus the premium paid for the call, and the long put price minus the premium paid for the put. Hence, the trader will need to see the stock move above $46 or below $34 to turn a profit.

If the trader were to sell the strangle, he or she would collect the $4 premium. The trader would, however, be exposed to unlimited risk to the upside and all the way down to zero on the downside. The maximum profit potential would be the $4 premium collected.

When to Put it on

The long strangle may be used to try to profit from two things: A large market move or a significant increase in implied volatility levels. Earnings or major economic announcements for which the trader expects a big move bu is unsure about the direction may be an appropriate time to use the long strangle.

If implied volatility levels of the options are very low compared to historical norms, the trader may look to purchase a strangle if he or she expects volatility levels to increase.

If a trader is looking to go short a strangle, he or she may use the strategy if they think that the market is likely to stay within a relatively tight range. They may also sell the strangle if they believe that implied volatility levels are high compared to the norm, and will revert to the mean. Due to their unlimited risk, however, such positions should only be used by those willing an able to assume the risks involved.

Pros of Strategy

The long strangle can have some advantages. The biggest advantages of the long strangle are their defined risk and unlimited profit potential. When purchasing a long strangle, the trader cannot lose more than the premium paid.

The pros of selling the strangle are that it can potentially profit over a wide range and also takes advantage of the time decay of options.

Cons of Strategy

The long strangle does also have some significant cons. Depending on how the position is structured, it may take a very significant market move to turn a profit. Not only that, but the position can lose money through time decay if such a market move does not happen fast enough. The long strangle can also lose money if IV levels of the options see a sharp decline.

The short strangle has some significant drawbacks as well. The unlimited risk that comes with such a position makes it unsuitable for most investors. The position can lose money not only if the market does make a big move, but also if IV levels increase.

Risk Management

There are several ways to manage risk for a long strangle. A simple, yet effective method is to determine an exit point before putting the trade on. For example, if the trader pays $8 for a strangle, he or she could decide to cut the position if it declines in value to $6. The trader can also use other parameters such as time to close the trade. For example, if the trader initiates a long strangle with 60 days until the options expire, he or she could decide to close it win, lose or draw once the options have 30 days left until they expire.

The risk management for a short strangle is far more tricky. Markets can and do make significant and major moves quickly, and the trader must have some type of exit strategy in place. Even with good risk management techniques, however, the trader is still exposed to unlimited risk and may not be able to exit a position at desired levels.

Possible Adjustments

As with other options strategies, the long or short strangle can be adjusted. If a trader is making money on the call side of a long strangle, he or she may elect to sell the put back to the market to recoup some of its cost. If the options are starting to decay rapidly, the trader may sell the strangle back to the market and purchase a new one with more time left. The strangle buyer can also purchase the wings of the trade. For example, they could sell a put against their long put to create a bear put spread.

A short strangle seller can also close either side of the spread. They can also purchase a long call or long put at some point to cap the risk on that side of the trade.